Cross border flows, with a bit of macroeconomics

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Note: This is a guest post by Paul Swartz.I appreciate Brad giving me the opportunity to fill in while he is on vacation.

Last Tuesday Timothy Geithner argued that a working economy requires a functioning banking system.This connection is conceptually clear to most people.If you can’t get a loan to go to school, buy a car or house or some consumer good, you are likely to delay or go without the consumption or investment. Forgone spending meaning forgone income for someone else.

If tight credit is a part of the problem now, easy access to credit was a key source of the getting us where we are today.Consider the following graph – based on the Fed’s Flow of Funds. It shows a tight correlation between the growth in home mortgage credit and the appreciation in the housing market (for the more technically minded, the quarterly correlation since 1980 is over 60%).

Correlation is not causation but it makes sense that easy access to credit would contribute to a rise in home prices and that a lack of credit could facilitate a housing collapse.

A valid question about this story is ‘did mortgage home prices appreciation increase credit or did credit increase home prices?’Likely a bit of both; as home price appreciation accelerated more people had the capacity to use their home as an ATM and take out a home equity loan.Cash-out refinances average 37.2 Billion between 1991 and 2000 and 152.7 Billion between 2001and 2005.A similar question can be asked on the downside.Namely did falling home prices – through its impact on the banking system – lead to a tightening of credit, or was a tightening of credit a cause of the home price depreciation.

The Fed flow of funds data allows for a decomposition of the sources of mortgage credit.What stands out is the growth of “private label” mortgage securitization from 2002 through 2006 – and the subsequent collapse of the private securization market. The agencies (Fannie, Freddie) initially offset some of the contraction in demand for mortgages from private issuers.They have not – in large part due the high level of credit extension – been able to maintain positive aggregate home mortgage credit growth.To be fair they were pseudo private companies so it is not clear that they should have taken on a moderator role at all; in fact if they were simply trying to preserve their own existence they should have contracted credit not expanded it.It is interesting to compare the agencies moderating role in 1990. At that time they offset the contraction in bank lending and home mortgage credit continued to growth.[See a combined graphic on the CGS home page].

Doubts remain about the health of key financial institutions — in large part because they extended a lot of credit against homes and kept far more of that credit on their balance sheets than most analysts expected (and certainly seem to have been more exposed than their regulators realized).

Many emerging economies that previously borrowed a lot now cannot borrow. They will have to cut back. That includes previously high-flying emerging economies like Dubai.

Economic activity is slowing globally — and the risk is that will slow more.

Let me give credit to Dr. Roubini (my former boss) for holding firm to his conviction that vulnerabilities were building even as it seemed, at least for a while, that the US economy would be able to shrug off a fall in investment in new homes.

I was on CNBC on Thursday – and the planned segment on the role non-democratic governments play in financing US deficits morphed into a discussion of Chinese and Russian Agency holdings. The segment was hyped as “Do America’s creditors own the US” but the actual discussion swerved the other way: America’s creditors now depend on the US government to bail them out of their bad investment in Agency bonds. The implication seemed to be that the US still held the upper hand.

Count me unconvinced.

No doubt any large debtor does have leverage over its creditors.

Moreover, many countries finance the US not because they like US financial assets but rather because they want to hold their exchange rates down in order to support their export sectors.* They certainly haven’t done so for the returns. That gives the US a bit of room to maneuver: the US was able to attract central bank financing even as it cut US interest rates and the dollar slid.

Finally, the sheer scale of the surpluses in the oil-exporting economies and China limits their options. China and the oil-exporters will combine to run a $1 trillion dollar surplus. That implies a $ 1 trillion deficit elsewhere in the global economy. India’s $1 trillion economy cannot support a $1 trillion deficit. Realistically, that kind of surplus has to be offset by a large deficit in the US and Europe. There is a reason why the Gulf’s purchases of US assets almost certainly rose after Dubai Ports World, and CNOOC/ Unocal didn’t stop China from financing the US. Sovereign wealth funds options are a bit more limited that is sometimes claimed — at least at a macro level.

The alternative to large-scale purchases of US financial assets is even larger scale purchases of European financial assets, or policy changes that reduce the surplus of the oil-exporting economies and China.

But the United States isn’t in a position where it can disregard its creditors either. The US now relies heavily on central bank purchases of Treasury and Agency bonds – what I have called the quiet bailout – to sustain its current account deficit. Without that flow, the US couldn’t run a counter-cyclical fiscal policy – and the Agencies couldn’t step up their purchases of mortgages to offset a collapse in the market for “private” mortgage backed securities. America’s creditors couldn’t stop financing the US without provoking a sharp fall in US demand that would damage their export sectors – but the US also cannot avoid a far large contraction that has happened to date without ongoing central bank financing.

Central bank holdings of Agencies at the New York Fed have fallen by $9.4b this month (from $981.7b to 972.3b), while central bank holdings of Treasuries are up by close to $28.4b (from $1394.6b to 1423.0 b)

Most central banks hold the bonds the Agencies themselves issue, not the bonds they guarantee. But there is a big exception: China. And China too seems to be scaling back its purchases. In the course of a (good) article on the Agencies, the Economist notes that China was — until recently — buying $5 billion of Agency MBS a week.
The situation in agency-backed MBS is even worse, with foreign buyers all but on strike. China’s central bank, which alone had been lapping up more than $5 billion-worth a month, has barely touched the stuff in recent weeks.

$5 billion a month is a large sum: $60 billion annualized. But it seems a bit low to me. The Treasury survey indicates that China bought nearly $100b of Agency MBS between June 2006 and June 2007 (bringing total Chinese holdings of Agency MBS above $200 billion), and Chinese reserve growth has picked up substantially since last June. (Edited from the initial post, see the note below)

Over the last year (think the period after the subprime crisis), central bank holdings of Agencies and Treasuries have increased by $419.5 billion — with a clear shift toward Treasuries recently after a long period where Agency holdings were growing faster than Treasuries. This quiet bailout far exceeds the roughly $35 billion that sovereign funds have invested in US banks. The US TIC captured most of these investments, and its shows $34.2 in official purchases of US equities over the last 12ms, with almost all the increase coming right after the big recapitalizations. The total would be higher if UBS and Barclays are added in — but also remember that many central banks don’t use the New York Fed’s facilities, and some rely on outside managers for even a Treasury and Agency portfolio. Central banks likely added more than $420 billion to their total holdings of Treasuries and Agencies over the last year.*

Americans have long criticized other countries for financial systems that direct credit to sectors favored by the government. Many argued that such directed credit contributed to the Asian crisis. It was inefficient. Countries would be far better off if they let the market pick winners. Or so the argument went.

Yet I think you can argue that the US right now isthe recipient of the largest government directed credit program in the world.

On one end, a private Chinese saver adds to their RMB account at a Chinese state bank. That state bank in turn buys the short-term bills the central bank issues to sterilize its reserve growth, or, put differently, the central bank finances its growing external portfolio by borrowing money rather than printing money. The central bank, having bought dollars in the foreign exchange market using the RMB it borrowed from the state banks, then buys US agency bonds — in effect, directing credit to the US housing market.

The New York Fed’s custodial holdings of Agencies haven’t grown at anything like their typical pace over the past few weeks. In the first two weeks of August, custodial holdings of Agencies fell by $6.7b while custodial holdings of Treasuries rose by $24.7b.

And — via Yves Smith — comes word that foreign central banks have been a bit more reluctant than usual to buy the debt the Agencies issue to refinance their retained mortgage portfolio. Lynn Adler of Reuters writes:

Overseas investors took an atypical back seat in Fannie Mae’s three-year note sale this week.

Central banks bought just 37 percent of the $3.5 billion issue, down from 56 percent in May’s $4 billion offering of the same maturity. Asia accounts took just 22 percent of the notes, down from 42 percent in May. “Most fixed income investors to whom we have spoken believe that a capital infusion by the government into Freddie and Fannie is a prerequisite for turning sentiment around in mortgage-backed securities and, by extension, in the broader fixed income markets,” Barclays Capital analysts Rajiv Setia and Philip Ling wrote in a report The longer the debate drags on, the more tentative foreign interest in the sector is likely to become. Even though the GSEs are adequately capitalized, investor confidence has been shaken,” the analysts wrote. “A slowdown in international investor interest remains the major risk factor for agency spreads, in our view.”

The Treasury’s bailout plan for Agencies sought to retain the Agencies current “hybrid” structure, one where the Agencies continued to be privately owned even as they borrow in the market at (relatively) low spreads based more on the expectation that they are too big, too important and too Chinese to fail than on the strength of their balance sheets. Larry Summers noted: “almost every outside observer agrees that pre-crisis, the GSEs could only borrow because of their implicit government guarantees. Since the crisis their position has sharply deteriorated, and will deteriorate further.” The Treasury’s plan hinged in the first instance on strengthening the perception that the US government stood behind the Agencies rather than strengthening the Agencies actual balance sheets. And with ongoing deterioration in the housing market — and rising losses on Alt-A mortgages, it seems like the world’s central banks aren’t buying it.

A well-deserved one too. Nouriel stuck to his core views — housing was massively over-valued, the financial system was heavily exposed to a fall in home prices and the fall out from a fall in US home prices wouldn’t be contained either nationally or globally – when those views were decidedly unpopular.

Back in early 2007, there was a great deal of complacency among America’s financial leadership. Many thought macroeconomic volatility had been vanquished, and as a result financial volatility was justly low. High levels of leverage consequently made sense — and a range of asset market prices reflected this. In the language of the time: credit markets weren’t over-valued, equity markets were under-valued. Recessions – or at least severe recessions and financial crises – were things that happened to other countries, not the US. The US had survived the .com bubble with only a shallow downturn. The 2003-2006 rise oil prices hadn’t put a big dent in the US economy. The large US current account deficit reflected high savings abroad and the attractiveness of the US financial assets; the US, after all, had a comparative advantage in financial-engineering. The IMF wrote that “innovative US fixed income markets [provided] many assets which simply aren’t available elsewhere” (see p. 12). There wasn’t much too worry about.

Read Michael Lewis’ argument that Davos man spent too much time worrying. He wrote in 2007:

Oil prices double, the U.S. housing market tanks — no matter what happens, financial markets adjust quickly and without hysteria. There are obviously a few things to worry about just now in the world, but the inability of traders to find a sensible price for the spread between European junk and European Treasuries isn’t one of them. So why do these people waste so much of their breath and, presumably, thought, with their elaborate expressions of concern?

Even the IMF – which is paid to worry – was tired of worrying. In late January of 2007, Chris Giles of the FT ran an article, based on an interview with the IMF’s Deputy Managing Director, that was titled “Big risks to global economy receding.” I thought that captured the mood of those times well.

Over time, the focus of Nouriel’s concerns has shifted over time from the United States’ external deficit to the housing market and the financial system. But there has been a core consistency to his views: he never thought that it was healthy for the US to borrow heavily from the rest of the world to finance large fiscal deficits, high levels of consumption and lots of investment in suburban housing. And he thought this borrowing binge would end badly. Very badly.

Emerging market financial crises in the 1990s followed a fairly consistent pattern.

The country lost access to external financing.

The sector of the economy that had a large need for financing – firms in Asia, the government elsewhere – had to dramatically reduce its need for financing. Asian investment collapsed. Argentina swung from a fiscal deficit to a fiscal surplus (helped along by its default on its external debt). Turkey began to run large primary surpluses.

Financial balance sheets shrank; credit dried up.

The country’s currency fell sharply. And its current account swung into balance, if not a surplus.

That process was incredibly painful. Falls in GDP of 5% or more were not unknown. It also meant that after a year or so, most emerging markets had reached bottom. Their economies had adjusted, as had their currencies.

A year – almost – after its crisis, the US economy hasn’t endured a similar period of adjustment. Economic activity has slumped, but not fallen off a cliff. US households are pinched (and unhappy), but spending hasn’t collapsed. The US current account deficit has fallen, but not by much – the rise in the oil deficit has offset the fall in the non-oil deficit. Banks have depleted their capital, but I don’t think that they have – in aggregate – shrank their balance sheets. Then again some of the expansion of their balance sheets may not have been entirely voluntary, as off-balance sheet assets and liabilities moved on to the formal balance sheet.

The epicenter of the US financial crisis now seems to have shifted to Fannie Mae and Freddie Mac — the government sponsored enterprises that dominate the market for US housing finance. Few institutions matter more for the US economy. They currently buy or guarantee an astonishingly high fraction of all new mortgages in the US. Absent that financing, home prices would fall further — dragging down the value of a lot of the “private” mortgage-backed securities issued at the height of the crisis, and health of a lot of (troubled) private financial institutions.

But Fannie and Freddie aren’t just “too-big-to-fail” US financial institutions. Not anymore. They are now global financial institutions. They have been central to the process that has turned US mortgages into securities held by the world’s central banks. Official — meaning central bank — holdings of Agencies have soared over the past two years. The US “TIC” and survey data suggests that central banks now have at least $925 billion in “Agency debt.” That is almost certainly an understatement: the monthly TIC data tends to understate official purchases, leading to large revisions when the more accurate survey data is released in June. Total official holdings are likely above a trillion — or about 20% of the $5 trillion or so in Agency debt outstanding.

As a result, the governments of China and Russia are now almost as exposed to the “Agencies” as the US government.

Roubini is still (officially) at 70% and (unofficially) at 100%. Any doubts — check out the titles of his last ten blogs. Merrill hedges a bit with “could be” as high as 80%. But Merrill is still taking a rather bearish view for a company with a bull in its logo that has long branded itself as “bullish on America.”

I always thought of the Merrill bull as an equity bull. But maybe the Merrill bull is a bond bull?

Rosenberg – and the rest of the interest rate team at Merrill – aren’t shy about the market implication of their call on the US economy. Buy Treasuries. Merrill – via Bill Cara — thinks the 5 year bond will fall to 4% in the fourth quarter of 2007.

I would put Merrill (and apparently) HSBC as the most bearish of all the big economic research shops. UPDATE: BNP Paribas belongs here too …

Goldman has some bearish tendencies, but right now is a bit less bearish on the US than Merrill and bullish on the BRICs (and on the possibility of global decoupling).

I am talking about housing, of course. And it seems everyone else is too. Starting with the New York Times Magazine.

No wonder. Everyone wants to know what will happen to real estate prices. And to our real-estatecentriceconomy. Particularly now that Treasury yields are creeping up just a bit.

Make no mistake, real estate has boomed over the past few years in part because it has gotten lots of government support.

From China. In order to maintain its exchange rate peg, China has to spend 10% of its GDP a year, give or take, buying dollars – dollars that it then invests in Treasuries. That helps to keep Treasury yields down. And recently, the connection has gotten more direct: the US data suggests that China has stepped up its purchases of "corporate" bonds – widely thought to be mortgage-backed securities. Put differently, in order subsidize Chinese exports, China's central bank has to subsidize American real estate.

And from the US government. Roger Lowenstein reminds us that the US government spends far more subsidizing suburban (and wealthy urban) housing than subsidizing farming – though, for rather obvious reasons, the big suburban (and wealthy urban) dailies tend to editorialize about the ills of agricultural subsidies with more regularity. The mortgage interest tax deduction costs [strike taxpayers] the government $76 billion; agricultural subsidies are a comparative bargain at around $20 billion. [Updated, per the comments section]

New Independent Task Force Reports

India now matters to U.S. interests in virtually every dimension. This Independent Task Force report assesses the current situation in India and the U.S.-India relationship, and suggests a new model for partnership with a rising India.

Rates of heart disease, cancer, diabetes, and other noncommunicable diseases (NCDs) in low- and middle-income countries are increasing faster than in wealthier countries. The report outlines a plan for collective action on this growing epidemic.

The authors argue that the United States has responded inadequately to the rise of Chinese power and recommend placing less strategic emphasis on the goal of integrating China into the international system and more on balancing China's rise.

Campbell evaluates the implications of the Boko Haram insurgency and recommends that the United States support Nigerian efforts to address the drivers of Boko Haram, such as poverty and corruption, and to foster stronger ties with Nigerian civil society.